Eagle Bancorp Montana, Inc.: Form 10-Q for the period ended Mar 31, 2019

Overview

The Company’s primary business activity is the ownership of its wholly owned subsidiary, Opportunity Bank of Montana (the “Bank”). The Bank is a Montana chartered commercial bank that focuses on both consumer and commercial lending. It engages in typical banking activities: acquiring deposits from local markets and originating loans and investing in securities. Its deposits are insured by the Federal Deposit Insurance Corporation. The Bank’s primary component of earnings is its net interest margin (also called spread or margin), the difference between interest income and interest expense. The net interest margin is managed by management (through the pricing of its products and by the types of products offered and kept in portfolio), and is affected by changes in market interest rates. The Bank also generates noninterest income in the form of fee income and gain on sale of loans.

The Bank has a strong mortgage lending focus, with a large portion of its loan originations represented by single-family residential mortgages, which has enabled it to successfully market home equity loans, as well as a wide range of shorter term consumer loans for various personal needs (automobiles, recreational vehicles, etc.). In recent years, the Bank has also focused on adding commercial loans to its portfolio, both real estate and non-real estate. We have made significant progress in this initiative. The purpose of this diversification is to mitigate the Bank’s dependence on the residential mortgage market, as well as to improve its ability to manage its spread. Recent acquisitions have added to our agricultural loans, which generally have shorter maturities and nominally higher interest rates. This has provided additional interest income and improved interest rate sensitivity. The Bank’s management recognizes that fee income will also enable it to be less dependent on specialized lending and it now maintains a significant loan serviced portfolio which provides a steady source of fee income. Fee income is also supplemented with fees generated from the Bank’s deposit accounts. The Bank has a high percentage of non-maturity deposits, such as checking accounts and savings accounts, which allows management flexibility in managing its spread. Non-maturity deposits and certificates of deposits do not automatically reprice as interest rates rise. Gain on sale of loans also provides significant noninterest income in periods of high mortgage loan origination volumes. Such income will be adversely affected in periods of lower mortgage activity.

Management continues to focus on improving the Bank’s core earnings. Core earnings can be described as income before taxes, with the exclusion of gain on sale of loans and adjustments to the market value of the Bank’s loan servicing portfolio. Management believes that the Bank will need to continue to concentrate on increasing net interest margin, other areas of fee income and control of operating expenses to achieve earnings growth going forward. Management’s strategy of growing the bank’s loan portfolio and deposit base is expected to help achieve these goals as follows: loans typically earn higher rates of return than investments; a larger deposit base should yield higher fee income; increasing the asset base will reduce the relative impact of fixed operating costs. The biggest challenge to the strategy is funding the growth of the Bank’s balance sheet in an efficient manner. Though deposit growth has been steady, it may become more difficult to maintain due to significant competition and possible reduced customer demand for deposits as customers may shift into other asset classes.

The level and movement of interest rates impacts the Bank’s earnings as well. The Federal Open Market Committee changed the federal funds target rate from 1.50% to 2.50% during the year ended December 31, 2018. The rate remained at 2.50% at March 31, 2019.

From time to time the Bank has considered growth through mergers or acquisition as an alternative to its strategy of organic growth. On September 5, 2017, the Company entered into an Agreement and Plan of Merger with TwinCo, a Montana corporation, and TwinCo’s wholly-owned subsidiary, Ruby Valley Bank, a Montana chartered commercial bank to acquire 100% of TwinCo’s equity voting interests. The merger agreement provided that Ruby Valley Bank would merge with and into Opportunity Bank of Montana and that TwinCo would merge with and into the Company. Ruby Valley Bank operated 2 branches in Madison County, Montana. The transaction provided an opportunity to expand market presence and lending activities, particularly in agricultural lending. The acquisition closed January 31, 2018, after receipt of approvals from regulatory authorities, approval of TwinCo shareholders and the satisfaction of other closing conditions. The total consideration paid was $18.93 million and included cash consideration of $9.90 million and common stock issued of $9.03 million.

Effective January 1, 2019, Eagle completed its previously announced merger with Big Muddy Bancorp, Inc. (“BMB”), pursuant to an Agreement and Plan of Merger, dated as of August 21, 2018, by and among Eagle, Opportunity Bank of Montana, BMB and BMB’s wholly-owned subsidiary, The State Bank of Townsend, a Montana chartered commercial bank. At the effective time of the Merger, BMB merged with and into Eagle, with Eagle continuing as the surviving corporation. The State Bank of Townsend operated four branches in Townsend, Dutton, Denton and Choteau, Montana. The transaction provided an opportunity to expand market presence and lending activities, throughout the state. The acquisition closed after receipt of approvals from regulatory authorities, approval of BMB shareholders and the satisfaction of other closing conditions. The total consideration paid was $16.44 million and it was primarily related to common stock issued.

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Financial Condition

Comparisons of financial condition in this section are between March 31, 2019 and December 31, 2018.

Total assets were $979.60 million at March 31, 2019, an increase of $125.70 million, or 14.7%, from $853.90 million at December 31, 2018. The increase was largely due to the change in loans receivable significantly impacted by the acquisition of BMB. Loans receivable increased by $110.59 million, or 18.1%, to $720.92 million at March 31, 2019, from $610.33 million at December 31, 2018. Total liabilities were $867.31 million at March 31, 2019, an increase of $108.21 million, or 14.3%, from $759.10 million at December 31, 2018. The increase was mainly due to an increase in deposits largely due to the BMB acquisition. Total deposits increased by $114.44 million, or 18.3%, to $741.05 million at March 31, 2019, from $626.61 million at December 31, 2018.

Balance Sheet Details

Investment Activities

The following table summarizes investment activities:

(Dollars in Thousands)

Securities available-for-sale were $140.16 million at March, 31, 2019, a decrease of $2.01 million, or 1.4%, from $142.17 million at December 31, 2018. The largest decrease in securities available-for-sale was in mortgage-backed securities and it was due to principal payments.

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Lending Activities

The following table includes the composition of the Bank’s loan portfolio by loan category:

(Dollars in thousands)

(1) Excludes loans held-for-sale.

Loans receivable, net increased $110.59 million to $720.92 million at March 31, 2019 due largely the BMB acquisition. The BMB acquisition included $89.20 million of acquired loans. Excluding acquired loans, loans receivable increased by $21.39 million. Including acquired loans, total commercial real estate loans increased $66.55 million, total commercial loans increased $39.37 million, home equity loans increased $2.48 million, consumer loans increased $2.47 million and total residential loans increased $206,000. Total loan originations were $127.88 million for the three months ended March 31, 2019, with total residential 1-4 family accounting for $78.98 million of the total. Total commercial real estate originations were $31.09 million. Total commercial and home equity loan originations totaled $11.29 million and $4.37 million, respectively, for the same period. Consumer loan originations totaled $2.15 million. Loans held-for-sale increased by $757,000, to $8.08 million at March 31, 2019 from $7.32 million at December 31, 2018.

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Lending Activities – continued

Nonperforming Assets. Generally, our collection procedures provide that when a loan is 15 or more days delinquent, the borrower is sent a past due notice. If the loan becomes 30 days delinquent, the borrower is sent a written delinquency notice requiring payment. If the delinquency continues, subsequent efforts are made to contact the delinquent borrower, including face to face meetings and counseling to resolve the delinquency. All collection actions are undertaken with the objective of compliance with the Fair Debt Collection Act.

For mortgage loans and home equity loans, if the borrower is unable to cure the delinquency or reach a payment agreement, we will institute foreclosure actions. If a foreclosure action is taken and the loan is not reinstated, paid in full or refinanced, the property is sold at judicial sale at which we may be the buyer if there are no adequate offers to satisfy the debt. Any property acquired as the result of foreclosure, or by deed in lieu of foreclosure, is classified as real estate owned until such time as it is sold or otherwise disposed of. When real estate owned is acquired, it is recorded at its fair market value less estimated selling costs. The initial recording of any loss is charged to the allowance for loan losses. Subsequent write-downs are recorded as a charge to operations. As of March 31, 2018, the Bank had $354,000 of real estate owned.

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Lending Activities – continued

The following table sets forth information regarding nonperforming assets:

(Dollars in Thousands)

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Deposits and Other Sources of Funds

The following table includes deposit accounts by category:

(Dollars in Thousands)

Deposits increased by $114.44 million, or 18.3%, to $741.05 million at March 31, 2019 from $626.61 million at December 31, 2018. The increase was largely due to increased deposits as a result of the BMB acquisition. Excluding acquired deposits, total deposits increased by $21.73 million. Including acquired deposits, certificates of deposit increased by $40.01 million, noninterest checking increased by $37.29 million, savings increased by $16.76 million, money market increased by $14.06 million and interest bearing checking increased by $6.32 million.

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The following table summarizes borrowing activity:

(Dollars in Thousands)

FHLB advances and other borrowings decreased by $9.91 million, or 9.7%, to $92.31 million at March 31, 2019 from $102.22 million at December 31, 2018. The decreased borrowings are due in part to acquired deposits exceeding acquired loans.

Shareholders’ Equity

Total shareholders’ equity increased $17.48 million, or 18.4%, to $112.29 million at March 31, 2019 from $94.81 million at December 31, 2018. This was primarily the result of stock issued in connection with the BMB acquisition of $16.44 million. The increase was also due to net income of $1.18 million and other comprehensive income of $1.13 million. These increases were slightly offset by treasury stock purchased for $732,000 and dividends paid of $597,000.

Analysis of Net Interest Income

The Bank’s earnings have historically depended primarily upon net interest income, which is the difference between interest income earned on loans and investments and interest paid on deposits and any borrowed funds. It is the single largest component of Eagle’s operating income. Net interest income is affected by (i) the difference between rates of interest earned on loans and investments and rates paid on interest bearing deposits and borrowings (the “interest rate spread”) and (ii) the relative amounts of loans and investments and interest bearing deposits and borrowings.

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Analysis of Net Interest Income – continued

The following table includes average balances for balance sheet items, as well as, interest and dividends and average yields related to the average balances. All average balances are daily average balances. Non-accrual loans were included in the computation of average balances, but have been reflected in the table as loans carrying a zero yield. The yields include the effect of deferred fees and discounts and premiums that are amortized or accreted to interest income or expense.

For the Three Months Ended March 31,

(Dollars in Thousands)

(1) Includes loans held-for-sale.

(2) Interest rate spread represents the difference between the average yield on interest earning assets and the average rate on interest bearing liabilities.

(3) Net interest margin represents income before the provision for loan losses divided by average interest earning assets.

(4) For purposes of this table, tax exempt income is not calculated on a tax equivalent basis.

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Rate/Volume Analysis

The following table presents the dollar amount of changes in interest income and interest expense for major components of interest earning assets and interest bearing liabilities. For each category of interest earning assets and interest bearing liabilities, information is provided on changes attributable to: (1) changes in volume multiplied by the old rate; (2) changes in rate, which are changes in rate multiplied by the old volume; and (3) changes not solely attributable to rate or volume, which have been allocated proportionately to the change due to volume and the change due to rate.

(In Thousands)

Results of Operations for the Three Months Ended March 31, 2019 and March 31, 2018

Net Income. Eagle’s net income for the three months ended March 31, 2019 was $1.18 million compared to $573,000 for the three months ended March 31, 2018. This increase of $610,000 was due to an increase in net interest income after loan loss provision of $2.42 million and an increase in noninterest income of $1.26 million. These increases were partially offset by an increase in noninterest expense of $2.95 million and an increase in income tax expense of $134,000. Basic and diluted earnings per share were both $0.18 for the current period. Basic and diluted earnings per share were both $0.11 per share for the prior year comparable period.

Net Interest Income. Net interest income increased to $9.38 million for the three months ended March 31, 2019, compared to $6.85 million for the same quarter in the prior year. This increase of $2.53 million, or 36.9%, was primarily the result of an increase in interest and dividend income of $3.16 million, slightly offset by an increase in interest expense of $636,000.

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Results of Operations for the Three Months Ended March 31, 2019 and March 31, 2018 – continued

Interest and Dividend Income. Interest and dividend income was $11.12 million for the three months ended March 31, 2019, compared to $7.96 million for the three months ended March 31, 2018, an increase of $3.16 million, or 39.7%. Interest and fees on loans increased to $10.05 million for the three months ended March 31, 2019 from $6.87 million for the three months ended March 31, 2018. This increase of $3.18 million, or 46.3%, was due to an increase in the average balance of loans, as well as an increase in the average yield of loans for the three months ended March 31, 2019. Average balances for loans receivable, net, including loans held-for-sale, for the three months ended March 31, 2019 were $726.66 million, compared to $573.02 million for the prior year period. This represents an increase of $153.64 million, or 26.8% and was largely impacted by the BMB acquisition and a full quarter impact of the TwinCo acquisition. The average interest rate earned on loans receivable increased by 75 basis points, from 4.86% for the three months ended March 31, 2018, to 5.61% for the three months ended March 31, 2019. Interest and dividends on investment securities available-for-sale decreased slightly by $31,000 or 3.1% for the three months ended March 31, 2019. Average balances for investments decreased to $140.80 million for the three months ended March 31, 2019, from $151.32 million for the three months ended March 31, 2018. However, average interest rates earned on investments increased slightly from 2.65% for the three months ended March 31, 2018, to 2.76% for the three months ended March 31, 2019.

Interest Expense. Total interest expense for the three months ended March 31, 2019 was $1.75 million compared to $1.11 million for the three months ended March 31, 2018. The increase of $636,000, or 57.3%, was due to an increase in interest expense on deposits, as well as an increase in interest expense on advances from FHLB and other borrowings including long-term debt. The average balance for total deposits was $724.82 million for the three months ended March 31, 2019 compared to $605.57 million for the three months ended March 31, 2018. This increase was due in part to the BMB acquisition and a full quarter impact of the TwinCo acquisition. The overall average rate on total deposits was 0.44% for the three months ended March 31, 2019 compared to 0.29% for the three months ended March 31, 2018. The average borrowing balance for advances from FHLB and other borrowings including long-term debt increased from $108.89 million for the three months ended March 31, 2018 to $125.51 million for the three months ended March 31, 2019. In addition, the average rate paid increased from 2.55% for the three months ended March 31, 2018, to 3.10% for the three months ended March 31, 2019.

Loan Loss Provision. Loan loss provisions are charged to earnings to maintain the total allowance for loan losses at a level considered adequate by management of the Bank, to provide for probable loan losses based on prior loss experience, volume and type of lending conducted by the Bank and past due loans in the portfolio. The Bank’s policies require a review of assets on a quarterly basis. The Bank classifies loans as well as other assets if warranted. While management believes it uses the best information available to make a determination with respect to the allowance for loan losses, it recognizes that future adjustments may be necessary. The Bank recorded $604,000 in loan loss provisions for the three months ended March 31, 2019 and $502,000 for the three months ended March 31, 2018. Management believes the level of total allowances is adequate. Total nonperforming loans, including restructured loans, net, was $5.32 million at March 31, 2019 compared to $3.77 million at December 31, 2018. The Bank has $354,000 in other real estate owned and other repossessed assets at March 31, 2019 compared to $107,000 at December 31, 2018.

Noninterest Income. Total noninterest income was $3.94 million for the three months ended March 31, 2019 compared to $2.68 million for the three months ended March 31, 2018. The increase of $1.26 million, or 47.0%, is largely due to an increase in net gain on sale of loans of $1.16 million. During the three months ended March 31, 2019, $72.32 million of mortgage loans were sold compared to $47.01 million for the three months ended March 31, 2018.

Noninterest Expense. Noninterest expense was $11.27 million for the three months ended March 31, 2019 compared to $8.32 million for the three months ended March 31, 2018. The increase of $2.95 million, or 35.5%, is largely due to an increase in salaries and employee benefits expenses of $1.08 million. The increase in salaries expense is due in part to higher commission-based compensation related to the continued loan growth in both commercial and mortgage lending activities as well as the TwinCo and BMB acquisitions. In addition, acquisition costs increased $937,000 due to the BMB acquisition.

Income Tax Expense. Income tax expense was $261,000 for the three months ended March 31, 2019, compared to $127,000 for the three months ended March 31, 2018. The effective tax rate for both periods was 18.1%.

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Liquidity and Capital Resources

Liquidity

The Bank is required to maintain minimum levels of liquid assets as defined by the Montana Division of Banking and Federal Reserve Bank (“FRB”) regulations. The liquidity requirement is retained for safety and soundness purposes, and appropriate levels of liquidity will depend upon the types of activities in which the company engages. For internal reporting purposes, the Bank uses policy minimums of 1.0%, and 8.0% for “basic surplus” and “basic surplus with FHLB” as internally defined. In general, the “basic surplus” is a calculation of the ratio of unencumbered short-term assets reduced by estimated percentages of CD maturities and other deposits that may leave the Bank in the next 90 days divided by total assets. “Basic surplus with FHLB” adds to “basic surplus” the additional borrowing capacity the Bank has with the FHLB of Des Moines. The Bank exceeded those minimum ratios as of both March 31, 2019 and December 31, 2018.

The Bank’s primary sources of funds are deposits, repayment of loans and mortgage-backed and collateralized mortgage obligation securities, maturities of investments, funds provided from operations, and advances from the FHLB of Des Moines and other borrowings. Scheduled repayments of loans and mortgage-backed and collateralized mortgage obligation securities and maturities of investment securities are generally predictable. However, other sources of funds, such as deposit flows and loan prepayments, can be greatly influenced by the general level of interest rates, economic conditions and competition. The Bank uses liquidity resources principally to fund existing and future loan commitments. It also uses them to fund maturing certificates of deposit, demand deposit withdrawals and to invest in other loans and investments, maintain liquidity and meet operating expenses.

Liquidity may be adversely affected by unexpected deposit outflows, higher interest rates paid by competitors and similar matters. Management monitors projected liquidity needs and determines the level desirable, based in part on commitments to make loans and management’s assessment of the Bank’s ability to generate funds.

Capital Resources

As of March 31, 2019, the Bank’s internally determined measurement of sensitivity to interest rate movements as measured by a 200 basis point rise in interest rates scenario, increased the economic value of equity (“EVE”) by 6.5% compared to an increase of 2.3% as of December 31, 2018. The Bank is within the guidelines set forth by the Board of Directors for interest rate risk sensitivity in rising interest rate scenarios.

Beginning January 1, 2015, community banking organizations became subject to a new regulatory rule recently adopted by federal banking agencies (commonly referred to as Basel III). The new rule establishes a new regulatory capital framework that incorporates revisions to the Basel capital framework, strengthens the definition of regulatory capital, increases risk-based capital requirements, and amends the methodologies for determining risk-weighted assets. These changes are expected to increase the amount of capital required by community banking organizations. Basel III includes a multiyear transition period from January 1, 2015 through December 31, 2019.

The Bank’s Tier 1 leverage ratio, as measured under State of Montana and FRB rules, increased from 11.222% as of December 31, 2018 to 11.272% as of March 31, 2019. The Bank’s capital position helps to mitigate its interest rate risk exposure.

As of March 31, 2019, the Bank’s regulatory capital was in excess of all applicable regulatory requirements and the Bank is deemed “well capitalized” pursuant to State of Montana and FRB rules. At March 31, 2019, the Bank’s total capital, Tier 1 capital, common equity Tier 1 capital and Tier 1 leverage ratios were 15.320%, 14.352%, 14.352% and 11.272%, respectively, compared to regulatory requirements of 10.500%, 8.500%, 7.000% and 4.000%, respectively. All of these ratios with the exception of the Tier 1 leverage ratio include the capital conservation buffer of 2.500% phased-in beginning January 1, 2019.

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Liquidity and Capital Resources – continued

Capital Resources – continued

(Unaudited)

(Dollars in Thousands)

Interest Rate Risk

Interest rate risk is the potential for loss of future earnings resulting from adverse changes in the level of interest rates. Interest rate risk results from several factors and could have a significant impact on the Company’s net interest income, which is the Company primary source of net income. Net interest income is affected by changes in interest rates, the relationship between rates on interest bearing assets and liabilities, the impact of interest fluctuations on asset prepayments and the mix of interest bearing assets and liabilities.

Although interest rate risk is inherent in the banking industry, banks are expected to have sound risk management practices in place to measure, monitor and control interest rate exposures. The objective of interest rate risk management is to contain the risks associated with interest rate fluctuations. The process involves identification and management of the sensitivity of net interest income to changing interest rates.

The ongoing monitoring and management of this risk is an important component of the Company’s asset/liability committee, which is governed by policies established by the Company’s Board that are reviewed and approved annually. The Board delegates responsibility for carrying out the asset/liability management policies to the Bank’s asset/liability committee. In this capacity, the asset/liability committee develops guidelines and strategies impacting the Company’s asset/liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The Company’s goal of its asset and liability management practices is to maintain or increase the level of net interest income within an acceptable level of interest rate risk. Our asset and liability policy and strategies are expected to continue as described so long as competitive and regulatory conditions in the financial institution industry and market interest rates continue as they have in recent years.

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Interest Rate Risk – continued

The Bank has established acceptable levels of interest rate risk for an instantaneous and permanent shock in rates as follows: Projected net interest income over the next twelve months (i.e. year-1) will not be reduced by more than 15.0% given an immediate change in interest rates of up to 200 basis points (+ or -). Furthermore, projected net interest income over the subsequent twelve months (i.e. year-2) will not be reduced by more than 15.0%.

The following table includes the Bank’s net interest income sensitivity analysis.

Impact of Inflation and Changing Prices

Our financial statements and the accompanying notes have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. The impact of inflation is reflected in the increased cost of our operations. Interest rates have a greater impact on our performance than do the general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As of the end of the period covered by this report, we conducted an evaluation under the supervision and with the participation of our management including our Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”) of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, including to ensure that information required to be disclosed by us in the reports filed or submitted by us under the Exchange Act is accumulated and communicated to management to allow timely decisions regarding required disclosure. Based on that evaluation, our CEO and CFO concluded that as of March 31, 2019, our disclosure controls and procedures were effective. During the last quarter, there were no changes in the Company’s internal control over financial reporting that have materially affected, or were reasonably likely to materially affect, the Company’s internal control over financial reporting.

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There have not been any material changes in the risk factors previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018.